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Unformatted text preview: Ups and Downs: Valuing Cyclical and Commodity Companies Aswath Damodaran Stern School of Business, New York University September 2009 Ups and Downs: Valuing Cyclical and Commodity Companies Abstract Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable (the commodity price or the growth in the underlying economy) than it is on firm specific characteristics. Thus, the value of an oil company is inextricably linked to the price of oil just as the value of a cyclical company is tied to how well the economy is doing. Since both commodity prices and economies move in cycles, the biggest problem we face in valuing companies tied to either is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluations. In this paper, we look at the consequences of this dependence on cycles and how best to value companies that are exposed to this problem. Ups and Downs: Valuing Cyclical and Commodity Companies Abstract Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable (the commodity price or the growth in the underlying economy) than it is on firm specific characteristics. Thus, the value of an oil company is inextricably linked to the price of oil just as the value of a cyclical company is tied to how well the economy is doing. Since both commodity prices and economies move in cycles, the biggest problem we face in valuing companies tied to either is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious misvaluations. In this paper, we look at the consequences of this dependence on cycles and how best to value companies that are exposed to this problem. Uncertainty and volatility are endemic to valuation, but cyclical and commodity companies have volatility thrust upon them by external factors the ups and downs of the economy with cyclical companies, and movements in commodity prices with commodity companies. As a consequence, even mature cyclical and commodity companies have volatile earnings and cash flows. When valuing these companies, the danger of focusing on the most recent fiscal year is that the resulting valuation will depend in great part on where in the cycle (economic or commodity price) that year fell. If the most recent year was a boom (down) year, the value will be high (low). In this paper, we look at how best to deal with the swings in earnings that characterize commodity and cyclical companies in both discounted cash flow and relative valuations. We argue that trying to forecast the next cycle is not only futile but dangerous and that it is far better to normalize earnings and cash flows across the cycle....
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